Transports Get Heebie-Jeebies

11/2/2009


Buying stocks early in the economic cycle is a time-tested route to success, and most economists believe U.S. gross domestic product has stopped shrinking after a deep and prolonged decline. In fact, consensus estimates project positive GDP growth for every quarter through the end of 2010.

Bears mostly concede the economy has stopped shrinking but worry stocks are vulnerable, with many arguing one or both of the following:

1. Stocks have rallied too far ahead of the economy. The rally since March has been fueled entirely by expanding price/earnings ratios, and stocks already reflect expectations of a much-improved economy.

2. The economy is on an unsustainable sugar high, hopped up on massive fiscal stimulus and 0% interest rates. Once the private sector is forced to stand on its own two feet, a relapse into recession or subpar growth is likely.

Both arguments deserve consideration — and both highlight the importance of watching the Dow Transports. Perhaps because transportation companies are in the nitty-gritty business of moving things from one place to another, they tend to be good barometers of expectations for the real economy.

Regarding the bears’ first point, valuations for the 20 Dow Transports suggest investors are betting on an earnings rebound. For the 15 components with trailing price/earnings ratios between 0 and 75, the median P/E is 18 — up from nine in March and above the norm of 16 since 1990. Median valuations are also above long-term norms based on price/book, price/cash flow, and price/sales ratios.

Regarding the bears’ second point, the Transports’ recent price action is worrisome but inconclusive. Railroad, trucking, airline, and airfreight stocks have slumped in reaction to September-quarter results, suggesting investors are losing confidence in the earnings recoveries forecast for next year.

Our advice for investors

The Transports gained 88% from March 9 to Oct. 20, so a pullback is to be expected at some point. However, if the Transports’ recent dip turns into a bona fide secondary correction, some investors may be surprised by the extent of the decline. Typical one-third to two-thirds retracements of the March-to-October advances would bring the Transports to 3,412 to 2,780 and the Dow Industrials to 8,910 to 7,729.

As a hedge, we recommend that subscribers hold 25% of equity portfolios in a short-term bond fund. Also, emphasize attractively valued shares of companies capable of growing in a sluggish economy, including AmerisourceBergen ($23; ABC), CVS ($36; CVS), Hospira ($47; HSP), and IBM ($121; IBM).


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